DISCUSSION PAPER SERIES No. 3742 CRISES AND PUNISHMENT: MORAL HAZARD AND THE PRE-1914 INTERNATIONAL FINANCIAL ARCHITECTURE Marc Flandreau INTERNATIONAL MACROECONOMICS ABCD www.cepr.org Available online at: www.cepr.org/pubs/dps/DP3742.asp www.ssrn.com/xxx/xxx/xxx ISSN 0265-8003 CRISES AND PUNISHMENT: MORAL HAZARD AND THE PRE-1914 INTERNATIONAL FINANCIAL ARCHITECTURE Marc Flandreau, Institut d’Etudes Politiques de Paris and CEPR Discussion Paper No. 3742 February 2003 Centre for Economic Policy Research 90–98 Goswell Rd, London EC1V 7RR, UK Tel: (44 20) 7878 2900, Fax: (44 20) 7878 2999 Email: [email protected], Website: www.cepr.org This Discussion Paper is issued under the auspices of the Centre’s research programme in INTERNATIONAL MACROECONOMICS. Any opinions expressed here are those of the author(s) and not those of the Centre for Economic Policy Research. Research disseminated by CEPR may include views on policy, but the Centre itself takes no institutional policy positions. 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Copyright: Marc Flandreau CEPR Discussion Paper No. 3742 February 2003 ABSTRACT Crises and Punishment: Moral Hazard and the Pre-1914 International Financial Architecture This Paper argues that the backbone of the pre-1914 international financial architecture was the concern about moral hazard. No decentralized system can leave without safeguards against free riding and this typically means that problem countries must find by themselves the means to fix their domestic problems. We review the origins of crises as well as the remedies that were commonly applied one century ago and find that the international financial world was fairly similar to the setting in which we live today, and for the same reasons. Today, just like one century ago, in the absence of an international lender of last resort with huge regulatory powers, countries must muddle through, with the occasional – and imperfect – help of international finance. JEL Classification: F02, G14, N10 and N20 Keywords: financial architecture, financial crises, moral hazard, relationship banking and self-insurance Marc Flandreau Institut d’Etudes Politiques, Paris FNSP, 4, rue Michelet 75007 Paris FRANCE Tel: (33 1) 4046 7265 Fax: (33 1) 4407 0750 Email: [email protected] For further Discussion Papers by this author see: www.cepr.org/pubs/new-dps/dplist.asp?authorid=113661 Submitted 04 December 2002 CRISES AND PUNISHMENT: MORAL HAZARD AND THE PRE-1914 INTERNATIONAL FINANCIAL ARCHITECTURE Marc Flandreau Institut d’Etudes Politiques de Paris “C’est avec ces femmes qu’Oreste Dépense l’argent de Papa. Papa s’en fiche bien – au reste, Car c’est la Grèce qui paiera!” (“These are the women Orest Spends Daddy’s money with Daddy doesn’t care anyway For he knows that Greece will pay!”) Libretto from La Belle Hélène, a French musical by Jacques Offenbach (1864). This chapter’s basic premise is that the 19th century international financial order rested on two principles. The first was the notion that moral hazard was a formidable evil. That concern was a consequence of the Western principle of laissez-faire which flourished and expanded during that century. The permissive and inefficient Leviathan had been replaced by an open society which was based on individual responsibility. In its positive form, the fear of moral hazard was rooted in the Darwinian belief that only the fittest could survive, that the weakest did not deserve support, and that appropriate 1 reforms and policies, not a helping hand, was what was needed. In its religious version, it came along with the notion that sinners had to suffer to earn their redemption. The second building block provided intellectual foundations. It was the belief in universalism and causality, inherited from 18th century’s European Enlightenment. Universalism implied that there were economic laws that were valid everywhere, so that no country – contrary to what Russian nationalists were already saying – could claim to be an exception. These laws, once identified, could provide guidelines for the establishment of a “sound” currency. Causality implied that crises had their roots in the functioning of the economy, so that they could be explained in reference to the events that had surrounded them: crises were the consequences of decisions taken in normal times. In short, international macroeconomics was a science: the actual French name was “science des finances.” The political and intellectual principles went hand to hand. Science and morale were reinforcing each other. This point of view was widespread, and largely shared by authorised people. It was at the centre of a consensus between those actors involved in the macro-economy from an international point of view. These consisted of two main groups. On the one hand were international financiers, ranging from stock exchange people to the leading investment bankers who underwrote new government bond issues and had an important advising role in the process. On the other hand were the government officials in charge of running their country’s institutions in the ministries of finance and proto central banks. The exchanges between the two communities were numerous and important facilitating the flow of information and fostering a common understanding. Academia also participated in the debate, although its role was not prominent, especially in Europe. It is not that the questions that were being discussed had little 2 relevance for the subject of Political Economy – much to the contrary. However, there was a gap between the academic State of the Art which recognised a number of simple principles such as the quantity theory and the practical requirements of actual international financial problems. These problems were the subject matter of a discipline that had been mostly developed by practitioners with strong links with either governments or financial institutions: often, these experts made their way onto the academic world by writing books or becoming lecturers, rather than the other way round. Prominent authors (some of which being often remembered as “economists”) included, from West to East, Charles A. Conant, a former US treasury representative in London in the period of the dollar stabilisation of the 1870s, Léon Say, the French Minister of Finances, architect of the 1871–2 successful payment of the War indemnity to Germany and Rothschild protégé, Paul Leroy-Beaulieu the editor of L’Economiste Français, Ludwig von Mises, the Austrian ultra orthodox finance minister of the early 20th century, and Arthur Raffalovitch, the Paris based financial chronicler, occasional lecturer, but most prominently, Czar’s Paris agent for financial matters. These contemporaries had to come to grips with the real life problems of the pre-1914 era, not with the subsequent myth which emerged in the interwar of a absolutely tranquil period. The decade 1890 deserves from that point of view special attention for its was paved with international and national crises. While other turbulent periods had been experienced, the 1890s were to be remembered as a difficult time for the international financial system, and left deep prints in the architecture of global capitalism. The decade opened with the Argentinean default, followed by other suspension of interest payments in Greece, Portugal, Brazil. Banking crises occurred, both in developed countries such as Britain, the US, Australia, and in problem nations such as Portugal and Argentina, or Italy. Exchange rate turmoil followed with massive 3 devaluations in Greece, Portugal, Argentina and Brazil. “Twin” or “triplet” crises as they are now known were becoming a fact of life. Thus the popular textbook vision that the pre-1914 era was a wonderful place where crises juts never happened because countries believed in the merits of rules and carefully adhered to gold is a plain lie. Behind the facade of the gold standard, the men of the previous century had to construct mechanisms that would serve to limit the occurrence of crises and help them to deal with them once trouble was in. This chapter addresses this issue in the following way: Section I reviews the “origin” of crises from the vantage point of contemporary analyses, emphasising the contribution of earlier experiments in shaping a monetarist approach in which the quantity theory and later the tax based theory of money played a central role (section I). Section II reviews the remedies applied, showing from a discussion of the stabilisation plans of the period that they involved a mix of macroeconomic workouts and institutional reform (section II). Finally, section III how the monitoring of macroeconomic policies operated: we find that it rested upon a bilateral relation between a bankers and a customer states, with routine support being transformed in extensive help in periods of problem, but at reasonable conditions that reflected the information which bankers had of their client’s outlook (Section III). The conclusion makes a number of points on the importance of these findings for the analysis of the role of money doctors. DISEASES: THE ORIGIN OF CRISES Fiscal misconduct, the quantity theory, and exchange depreciation 4 Just like the modern “early warning indicators” literature, the macroeconomic wisdom of 19th century experts was based on history.